Have ETFs contributed to market volatility?

ETFs (exchange-traded funds) have come under some criticism over the past month, with the occasional lurid headline suggesting that ETFs both caused the stock market crash and moved away from their fundamentals, harming both financial markets and holders who transacted at poor prices.

We would dispute both those points.

Global ETF architecture has been built out in recent years from a small backwater, one that sceptics thought would only really appeal to retail investors, to the enormous industry which it is today. This brought more criticism; what would happen if there were more sellers than buyers, could this overwhelm the market and result in a cycle of forced selling at lower and lower prices?

In this coronavirus crash, market makers – many working from home – kept the show on the road, offering both liquidity and the ability to create and redeem units on an enormous scale.

Looking at the world’s most liquid ETF, the US-listed SPDR S&P 500 (SPY), Bloomberg reveals that it has had average daily volumes over the past 30 days of 184m shares, worth $43bn a day at current market prices. This has been achieved with a bid-ask spread of 0.0046%, effectively costing an investor with one million dollars just $46 in frictional costs to buy and sell.

To put that in context, the FTSE 100’s largest holding, HSBC, has had a bid-ask spread of 0.026%.

On the second point of ETF pricing moving away from fundamentals, it is true that in volatile markets ETFs can end the day pricing at a premium or discount to their net asset value (NAV). This is most apparent in fixed income, where the iShares Core £ Corporate Bond ETF (SLXX) closed at a discount to NAV of more than -6% for a few days. However it’s important to note that while ETFs are priced by many different market makers, the assets within them are only as liquid as the underlying asset class. SLXX has more than 450 positions, but not all of them will trade on any one day. Therefore ETF price dislocations can effectively represent the true price at which the market would trade at if all the underlying components were to trade.

A similar comparison can be made with the housing market. Rightmove might show thousands of London properties around the £1m mark, but if they all had to sell on one day the entire market would need to take a haircut.

Investing has certainly not been without its challenges over the past six weeks, and we are seeing more disruption in oil ETFs, which own futures contracts and have had problems with these pricing negatively. Yet this is just a small part of the ecosystem in a corner of the market that gets exposure using derivatives, rather than buying physical assets. All markets have their quirks – this is an area we have avoided – but overall we continue to believe that ETFs will continue to offer robust properties as a vehicle for long term asset allocations.